Fiscal Cliff-Hanger: Are we heading over?

Between Mayan predictions of Armageddon and America just days from tipping the world into recession, December is shaping up as a rather exciting month - if you're into cliff-hanger scenarios, that is...

What would it look like?

If, like me, you’re not too worried about medieval meso-American prophesies of Doomsday, your attention is more likely focused on the so-called ‘Fiscal Cliff’. The ramifications of America's political parties failing to come to an agreement are dire for the future of the US economy and its status as a leader and innovator of economic policy.

Fiscal Cliff Snapshot:

Highest tax rate to be moved to 39.6%

Overall taxes to rise by $6 trillion over 10 years

2013 taxes to rise by $347 billion

Defence spending to be cut by 9%

Social Security, Medicare and Medicaid to be cut by 8.2%

Total impact of tax hikes and spending cuts in 2013: $600 billion

Total estimated jobs lost as a result: 1 million over two years.

Chance of recession should automatic cuts kick in: Near certainty.

Is it likely?

So what is the likelihood of America backing over the cliff and slipping into financial Armageddon? Actually, not much, if any at all.

Here's the scenario: If there is no compromise on the immediate $500 billion dollars in combined increased taxes and reduced spending (about 4% of GDP), the country would spiral into recession. The resulting implosion would undo all the hard work done by the Government and the Federal Reserve in recent years. Inflation, unemployment and foreclosures would likely soar due to the rise in costs across the board. Healthcare, Defence and major economic contributors would all suffer, adding pressure to an already fragile economy. That's why we won't go over the Fiscal Cliff. There’s just too much riding on a deal being brokered or, at the very least an extension of the US debt ceiling.

The governing Democratic Party and its Republican counterparts have very different views. In a nutshell, the Republicans want to protect the wealthiest income earners and leave middle and low income earners to wear the brunt of the tax hikes. They contend that incentivising the top bracket will have a flow-on effect to the rest of the economy, that the top bracket already pays more than its share and that higher taxes will drive entrepreneurs overseas. While this small tax rise would affect just 2% of the working population, it is attracting 95% of the political attention.

Slicing and dicing taxes across different brackets won't make or break America's debt situation anyway. There are more important issues which need to be addressed, like the mess we like to call the US health system. Healthcare is the largest burden on the American economy. Little wonder, when a 10-minute ambulance ride can cost as much as $10,000! And in many cases, health insurance is not available to those who need it most. For this reason, Obama's original Healthcare reforms carried great merit. Sadly, Republican opposition watered them down so much there was little real change.

Then there is Defense. America spends more on defense than the next 13 largest countries combined - a lavish $700 billion per annum.

It is unlikely that America will topple over the edge of the fiscal cliff. They – and the world - have too much to lose. But things do have to change. The country is racking up about $3.5 billion in national debt PER DAY.

Back to basics:

Of course, making the country more productive is a better solution than hiking the taxes of the ‘rich’ who invest and grow the economy, or incentivising the poor, for that matter. One way the economy can be made more productive is by making the Dollar more attractive to foreign buyers of US made goods and services. Decreasing the value of the US dollar (and America is almost unique in being able to do this) is almost always to the detriment of its major trading partners. This is likely to continue as the Fed prepares for more bond purchases. (Good luck Australian exporters...)

Another part of the solution would be to encourage domestic saving and investment. It’s pretty simple math and comes down to thinking about one's future. This brings us to a major flaw in the existing Democratic policy of raising tax on dividends, which penalises citizens for investing. This tax increase may help reduce the deficit but it will slow investment growth and consumer spending in the long-term.

A further issue is the complex tax system that allows wealthy individuals and businesses to pay as little as 15% tax on earnings, due to a series of well-used ‘legal’ loop-holes. Just this week, Google announced it had avoided about $US2 billion ($A1.9 billion) in worldwide income taxes in 2011 by siphoning $US9.8 billion in revenue into a Bermuda shell company.

The solution:

A hybrid agreement is needed in which businesses and individuals who are making money pay their dues, without excessively penalising the middle-class and tomorrow's high income earners.

Going over the ‘cliff’ is unthinkable. The result would have a drastic impact on the US and global recovery. Hardly the Christmas present anyone wants...